How Floating Rate Debt Mutual Funds Reduce Interest Rate Risk

There are two main risks associated with a debt mutual fund: capital losses due to (1) an increase in interest rates since old bonds are not as valuables as new bonds that offer higher rates; (2) an actual default in the payment of interest or the possibility of default. In this post, I shall introduce a little-known class of fixed income funds – the floating rate debt mutual fund and discuss how it reduces interest rate risk.

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It is easy to understand how interest rate risk can be minimised theoretically. If the rates are about to fall, buy long-term bonds (usually gilts, but others too). The NAV of the fund would then increase if rates drop. Then hold on to them until rates are low and when they are about to increase again, sell them for a profit and shift to low-duration bonds that will not be affected as much when rates head north again.

This is the main mandate of dynamic bond funds. However, very few fund managers get this right and most of them are only a notch less risky than long-term gilts funds. This is why I recommend not buying dynamic bond funds.

Interest rate risk can be minimised with the help of floating rate bonds. This post is about how funds that use such bonds operate. I do not recommend buying such funds.This post is for information and my education only.

Floating Rate Bonds

Typically a bond has a fixed coupon rate. That is if a bond is purchased for Rs. 1000 and a coupon rate of 8% will pay out an annual interest of 8% x 1000 = Rs. 80. until the bond matures.

If my aim is to buy and hold, there is no problem. However, if I wish to sell the bond mid-tenure or if I am managing an open-ended debt mutual fund where the NAV depends on market value, I need to worry about the bond’s current market price.

If new bonds are available at 9%, then my bond will sell at a discount. If new bonds offer only 7% then I can demand a premium for mine if I wish to sell.

In a floating rate bond, the current market price of the bond is quite close to its face value (rs. 1000 above), but the interest rate payments will change with rate movements.

So one way to gain from interest rate movements is to buy more of such floating rate bonds when rates are about to move up, and shift to fixed rate bonds when they are about to fall. Of course this again, in theory as rate movements are not easy to predict (nothing related to the market is).

There are other methods by which rate sensitivity can be reduced.

1 Interest Rate Swaps

Suppose I hold a fixed rate bond and another party (call it ‘X’) holds a floating rate bond. I expect rates to move up and therefore ask X for an exchange of interest rate payments.

That is, I would receive his floating rate interest payments (less a price) and X would receive my fixed rate payments (plus a fee).

If my expectation goes to plan, I would receive more interest (due to rate hike) than X after all fees/expenses. If my call goes wrong, then I would lose interest. Or if X is not trustworthy, I would lose all interest payments.

However, the actual principal invested in the bonds are not swapped. Only coupon payments.

Conversely, if I am holding a floating rate bond and expect rates to fall, I would swap it for a fixed rate bond.

This is a simplistic explanation of a rate swap. Floating rate funds employ such swaps to a good extent.

2 Forward Rate Agreements

Reinvestment risk is an interest-rate risk that very few consider. Three years ago, If I had opened a bank FD, I would have got 8.5%. After maturity today, if I reinvest, I will get only about 7% or so. This is the reinvestment risk when rates fall in future.

A forward rate arrangement (FRA) is an agreement between two parties to pay only the excess interest rate. That is if current FD rates are 7% and I expect them to fall to 6% after a year, then I can reduce this reinvestment risk with a FRA.

In a FRA, I agree to pay or receive the difference between the current FD rate (7%) and say the RBI policy rate after a period of time. If the policy rate falls to 6%, then I will receive interest payment corresponding to the difference: 1%. So I will reinvest a little extra at a new lower rate, mitigating my loss.

If the rates move up to 8%, then I will have to pay the difference: 1%. I will lose some money but gain it over time as the new rate is higher.

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3 Interest Rate Futures

Suppose I buy a bond for Rs. 1000 today and expect rates to increase in future (say 6 months). This means his bond will lower in value. So I enter into a contract with another party to sell the bond at say Rs. 1005 after 6 months. This is known as a futures contract.

If after 6 months, the rates fall and the price of the bond drops to Rs. 950, I make a loss of Rs. 50 when I sell my bond. However, the other party promised to buy it from for Rs. 1005. So I make a profit of Rs. 55 in my futures contract. The net profit is Rs. 5.

By buying and selling a bond and its futures contract at the same time, I reduce or hedge interest rate risk.

There are other types of fixed income arbitrage and this is only a simplistic introduction to arouse interest.

Floating Rate Mutual Funds In India

Floating rate funds employ a combination of strategies, some of which are mentioned above to reduce rate risk.

These are funds with “floating” in their name (duh!!). Many other debt funds use swaps, FRA and IFs. So this is not an exhaustive list. The categories are mentioned to the right as classified by VR. UST is ultra short-term, ST is short-term.

Birla Sun Life Floating Rate Fund – Long Term Plan

UST

Birla Sun Life Floating Rate Fund – Short Term Plan

Liquid

DHFL Pramerica Short Term Floating Rate Fund

UST

HDFC Floating Rate Income Fund – Long Term Plan

ST

HDFC Floating Rate Income Fund – Short Term Plan – Wholesale Plan

UST

L&T Floating Rate Fund

UST

Reliance Floating Rate Fund – Short Term Plan

ST

UTI Floating Rate Short Term Fund – Regular Plan

UST

The standard recommendation is that floating rate funds do well when rates are expected to increase. This means that they would do not so well when rate falls or at least not gain as much.

I am surprised that none of these floating rate funds has a dominant gilt exposure. So from what I see, they seem to be mitigating interest rate risk associated with PSU, bank and corporate bonds. Which makes me wonder if this is even necessary! So my recommendation would be, explore more about these if interested, but do not invest in them. At least not before understanding more about them.

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1 Comment

Floating-rate funds can provide income investors with diversification and some protection from interest rate risk. They can be an alternative way to add some extra income to your yield-starved portfolio. Just make sure that you are comfortable with their risks.

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